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The Cash Bucket Your Dividend ETF Bypasses

Technology stocks have generated more than 50% of the dividend growth in the S&P 500 since the market peaked in late 2007 according to WisdomTree. Yet the $40 billion invested in three of the most popular dividend ETFs -- Vanguard Dividend Appreciation (VIG - News), iShares Dow Jones Select Dividend (DVY - News) and SPDR S&P Dividend (SDY - News) -- pretty much steers clear of the land of Apple (:AAPL), Microsoft (:MSFT) and Cisco Systems (:CSCO).

The iShares ETF has the highest tech exposure of the three, with a 6.8% allocation to the tech sector, less than half the sector's weight in the S&P 500.

The WisdomTree juggernaut, with $39 billion in assets tied to its proprietary ETFs, is out with a new fund to fill the tech gap for dividend seeking ETF investors. By tossing aside the common dividend portfolio screen that requires a company already have at least a 10-year track record of paying dividends, the WisdomTree U.S. Dividend Growth ETF (DGRW - News) opens the door wide for tech stocks that are more recent converts to the dividend religion. For example, Apple won't be eligible for the Vanguard portfolio until 2023 and Cisco in 2021. Both stocks are in the new WisdomTree portfolio; Apple is the largest stake at near 5%. Tech stocks account for 20% of the portfolio right now, the upper bound of WisdomTree's self-imposed single-sector limit.

While ditching the long-term dividend growth history requirement adds a bit of risk to this portfolio, WisdomTree makes an interesting counter-argument: the reliance on positive past dividend growth set's a floor (there must be dividend growth) but doesn't impose any sort of growth requirement. According to Wisdom Tree, the SPDR High-Yield Dividend Aristocrats index (the benchmark for the SPDR ETF) managed 2.8% average annual dividend growth over the past three year, barely ahead of inflation, and the two other big dividend ETFs averaged between 8%-9%.

By comparison, the WisdomTree Dividend Index, from which this new ETF is derived had 13.3% dividend growth.

Why all the harping on dividend growth? Ned Davis Research has documented that companies that increase their dividends have produced far better total returns over the past 40 years than companies that don't pay a dividend, or don't systematically increase the dividend on an annual basis. And just this week, Goldman Sachs increased its outlook for the stock market for the rest of this year and 2014, in large part on its estimation that S&P 500 dividend growth will average 11% this year and next. Dividend yield is the sexy headline in today's income-starved world, but dividend growth is where the smart money focuses.

In addition to its big tech stake, the consumer defensive, consumer discretionary and industrial sectors are also each at their 20% max in the WisdomTree portfolio. Given the dividend growth angle, what you won't find in this new ETF are utilities; the high yielding haven with anemic dividend growth that has been bid up to abnormally high valuations by undiscerning income investors. By comparison, the iShares Dow Jones Select Dividend ETF has about 30% invested in utilities. That said, WisdomTree U.S. Dividend Growth should still deliver a competitive yield. Its five largest holdings -- Apple, Microsoft, Wal-Mart (:WMT), Procter & Gamble (:PG) and Coca-Cola (:KO) -- all yield more than the 2% payout average for the S&P 500 and the 1.9% yield on the 10-year Treasury.

WisdomTree develops its own indexes and methodologies that grow out of its in-house financial analytics. For this portfolio it starts with the WisdomTree Dividend Index of more than 1,300 companies, and imposes a $2 billion minimum market cap. The next hurdle is that a company's earnings are at least equal to the dividend payout. WisdomTree considers that a telling metric for ferreting out companies with the ability to keep dividends growing without any financial engineering.

After that, winnowing the 300-stock portfolio is built from stocks that have the best combination of earnings growth and management quality. For earnings growth, WisdomTree uses forward-looking earnings projections. Quality is measured by a company's 3-year average return on assets and 3-year average return on equity. Both factors are given a 50% weight in the stock screening. The thinking here is that companies that excel at earnings growth, ROA and ROE are just the sort of companies with the financial make-up to keep up a strong pace of dividend growth. The final step is that each holding's weight is determined by the aggregate cash dividends it pays out (dividend per share x shares outstanding) rather than the more typical market cap or dividend yield weighting.

Comparing Apple's ROA and ROE to AT&T (:T), the largest position in the SPDR ETF that focuses on high-yielding dividend aristocrats, highlights the different approach.

[Full disclosure: Pitney Bowes (:PBI) is actually the largest holding in the SPDR Dividend ETF, but it recently announced a dividend cut, so it's an aristocrat that will be dethroned when the portfolio is re-constituted next January.]

There's no back-tested track record for WisdomTree's approach. That said, it clearly is taking aim at the very successful Vanguard Dividend Appreciation ETF, which also values growth far more than current yield. As this chart shows, Vanguard's focus on dividend growth trumps the more yield-focused portfolios over the long-term:

WisdomTree's main differentiator is its open-door policy on relatively new dividend payers that haven't yet established a 10-year record of dividend growth. While the biggest impact is seen in the tech sector, other stocks currently owned in the WisdomTree portfolio that aren't yet eligible for the Vanguard (10-year track record) ETF include Home Depot (:HD), Comcast (:CMSCA) and Boeing (:BA). Think of it as investing in dividend start-ups; more risk than the old reliables, but potentially more reward too. Stay tuned.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.